Small Companies Should Prepare Now for Higher Rates
The Fed also hints that a crackdown on credit is on the way

Small-business owners don't spend a lot of time worrying about the Delphic statements of Federal Reserve Chairman Alan Greenspan. But maybe they should this time. Greenspan's clear-cut warning on inflation, coupled with statements that all but encourage a crackdown on borrowers, could mean that the days of cheap and easy credit for small companies are coming to an end.

In testimony to Congress on July 21 and 22, Greenspan said the central bank is more worried about inflation than the possibility of an economic slowdown and that U.S. interest rates may have to rise. That's bad news for young and expanding companies that depend on credit. And it comes on top of reports the Fed issued earlier this month suggesting that bank lending standards have become way too lax. Since smaller borrowers are generally the most risky, economists say, they're usually the first to see their rates rise or to get frozen out entirely, when bankers turn cautious.

The one bright side, say financial experts, is that it could be awhile before Greenspan follows through. That leaves a window for business owners to nail down cheap loans and rethink their financial strategies. "For those that have the energy, I'm nudging my clients to think about it,'' says Richard Berenson, a partner at Berenson & Co., an accounting and financial consulting firm in New York. "The money is available. The rates are good. This is the time to borrow if you can make money on your money... Everybody's got to make hay when the sun shines."

Of the two problems, a moderate amount of inflation is easier to handle for small businesses than a credit crunch. Economists such as David Kresge of Dun & Bradstreet, which maintains a huge database on small businesses, says most of them can handle a modest rate rise as long as the economy is chugging along and generating new sales. But a credit crunch shuts down expansion. Ominously, some private lenders say they see why the Fed wants to clamp down. "There's a lot of debt and equity chasing capital," Michael Pralle, president of Equity Capital Group, a unit of GE Capital Services, who says he's seeing more leverage and riskier strategies. "If sales fall off, [the companies] may not have the cash flow to service the debt."

For now, however, small businesses are enjoying the fruits of excess, says Miles Stuchin, president of New York-based Access Capital Inc., a small-business investor and lender. Small to midsize companies have been getting attractive borrowing terms from their banks, such as rates pegged to the free-floating London Interbank Offered Rate (LIBOR), now around 5.65%. Those usually beat rates that are linked to the higher and more static prime rate, now 8.5%. In turn, Stuchin warns, many smaller businesses have gotten too confident in extending credit to their customers. "We're telling our clients to stay hedged, not to get overexposed to their clients," Sturchin says. He adds that this tighter attitude has already taken hold at his firm.

While a rise in rates may be tolerable, its effects on some weaker small businesses can't be ignored. One particularly sore spot is credit cards, which still carry double-digit rates of up to 20% -- many of them tied to the prime rate, making them one of the first casualties if the Fed pushes interest rates higher.

Todd McCracken, president of National Small Business United, a Washington-based advocacy group, says the organization's studies show that smaller businesses are increasingly using credit cards to fund cash flow needs, shunning banks to avoid the paperwork. On one level, that looks worse than it is, he notes, because many also use the cards adroitly and pay their bills off each month. A typical strategy, he explains, is to order something and pay by credit card when the bill comes, a month later. That pushes the payment out few more weeks, until the card bill is due.

"But you need to establish a relationship with a banker beyond your checking account," McCracken cautions. "You don't want to go hat in hand when there's a downturn or higher rates." His advice? "Use your strong balance sheet to get a line of credit now." For startups that have financed themselves on second mortgages, he adds, this is probably a good time to refinance.

Venture capitalists say young companies considering an initial public offering should also be watching the interest rate scenario closely. Simply put, higher rates mean investors are less likely to take the risk of owning stock. That makes venture capitalists nervous because they fear they won't be able to use an IPO as an "exit strategy." The net effect of rising rates: less credit for small business, says Rob Stein, a managing partner at Women's Growth Capital Fund, a venture capital outfit based in Wasington, D.C., that specializes in high-growth, women-owned companies. "The last six or seven years have been salad days for venture capital," Stein adds. "It will get tighter."

The same thought has occurred to Paula Wexler-Tarlow, vice-president for marketing and a partner in the chocolate dessert-topping maker Over The Top Corp., a less-than-year-old New York startup with under $500,000 in revenue. "We're too new to get money from a bank," she notes. But a rate hike or credit crunch could cloud plans for her company to buy its own bottling plant instead of using outside contractors.

What's more, she says, a hike would make it more expensive to carry receivables, and credit charges from suppliers would go up, making her company more likely to play it safe. If enough other companies start thinking that way, perhaps Chairman Greenspan may find himself talking about recession instead of inflation a few congressional appearances down the road.